New China leaders must steady economy in 2013 before driving reform

China's Communist Party chief Xi Jinping looks on during his meeting with U.N. General Assembly President Vuk Jeremic at the Great Hall of the People in Beijing December 27, 2012.

Reuters/Wang Zhao/Pool/Files

BEIJING (Reuters) - China's new leaders must stabilise the economy this year to keep employment high while avoiding a surge in housing prices and inflation that could undermine reforms needed to overhaul the country's export-oriented growth model.

Without stability, incoming President Xi Jinping and Premier Li Keqiang, who are set to be confirmed in March, have no chance of delivering a slew of reforms they say are needed now to tackle a host of financial, industrial and income imbalances that threaten China's future.

Failure to close one of the world's widest rich-poor gaps or deflate a dangerous property bubble could create a backlash that could even break the Communist Party's grip on power.

"Stabilising growth is a pre-condition for delivering on reform and the new leadership has a long list of urgent issues," said Xiang Songzuo, chief economist at the Agricultural Bank of China, one of the country's "Big Four" state-backed lenders.

"They have to prioritise," Xiang said.

INFLATION LEGACY

Many analysts say the top priority is to ensure growth does not deviate far from the 7.5 percent rate likely to be set as the 2013 target during China's annual meeting of parliament in March - too slow puts jobs at risk, too fast and speculative investment activity jumps.

The closing months of 2008 offer the most recent precedent.

Back then, the global financial crisis bought world trade to a near standstill, costing an estimated 20 million Chinese jobs and forcing Beijing into a hasty 4 trillion yuan stimulus package that inflated a real estate bubble and sent local governments on an infrastructure-led, borrowing binge.

China has fought since to contain the inflation and the 10.7 trillion yuan in local government debt it spawned.

Beijing does not relish a repeat and so must act, and with some urgency, given the imbalances inherent in the export-led, factory-driven development model China has followed since 1978.

Its new leaders must come up with ways to turn legions of cheap, assembly-line exporters into world-beating product-makers, while making domestic consumption the economy's prime focus to ensure growth is more balanced.

INGRAINED INEQUALITY

The most striking imbalance is its population of 1.3 billion people.

China has 2.7 million U.S. dollar millionaires and 251 billionaires, according to the Hurun Report, but 13 percent of its people live on less than $1.25 per day according to United Nations data and the average annual urban disposable income is just 21,810 yuan.

"The roots of inequality lie in the growth model adopted over three decades ago," said Yolanda Fernandez Lommen, head of the Asian Development Bank's China economics unit.

"Comprehensive reforms have to be implemented to address major constraints," she said.

Household registration, or Hukou, rules are seen by many analysts as China's most pressing reform item as a change there would address inequality and boost domestic demand, rebalancing the core growth drivers of the economy.

About 158 million migrant workers have entered cities from the 250 million-strong rural workforce, but are denied access to services like health and education, forcing them to save hard.

HSBC analysts believe changing Hukou will turn China's 31 provinces from the equivalent of poor, Third World countries into places generating wealth like a union of second-tier developed and top-tier developing nations by 2020.

Research by McKinsey predicts that 51 percent of China's urban households will be part of the global consumer mainstream by 2020, with disposable income of between $16,000 and $34,000. In 2010, the proportion was just 6 percent.

DOMESTIC CONSUMPTION

Raising domestic consumption would reduce export dependency.

Exports are worth around 30 percent of China's GDP and foreign demand or foreign-funded businesses support an estimated 200 million Chinese jobs.

Faltering foreign demand from the debt-ridden European Union and fiscally-challenged United States were the root cause of 2012's cooling growth.

But with exporters such a vital economic contributor, it makes no sense to shut them down. Instead Beijing wants to push Chinese firms up the value chain.

That, however, causes tension with foreign trading partners as Chinese firms seek to design and develop products they previously simply assembled and shipped for overseas customers.

China's No.1 television maker, TCL Corporation 000100.SZ, says it needs global scale to be able to innovate and compete even domestically.

"In China we have built a solid foundation from which we can go global, but China's market is not big enough. The Chinese market for TVs is only 20 percent of the global total," said Tomson Li, chairman and CEO of TCL Corporation.

Establishing manufacturing capability to serve the overseas markets which TCL targets is effectively the price of entry, said Li, whose firm has 20 such bases globally.

And that could be good for helping China unwind another major imbalance - a $3.3 trillion pile of foreign reserves, the world's largest.

Reform to allow Chinese firms to invest more freely overseas would address a capital flow imbalance currently contained by the imposition of strict controls that require the inflationary printing of vast quantities of yuan.

Ratings agency Fitch recommends broad financial liberalisation.

FINANCIAL LIBERALISATION

Improving transparency and regulation in domestic stock markets and boosting access to mutual fund managers to give consumers greater choice could also steer speculative capital away from the problem areas of real estate and shadow banking.

Credit in the shadow banking sector - wealth management investment and trust products that gather deposits for lending outside formal banking channels - is estimated at least $1 trillion by analysts and is growing nearly three times faster than traditional lending.

Shadow banking is a major source of capital for speculative real estate development which the government wants to curb.

China is expected to report on Friday that the economy expanded 7.7 percent last year, the slowest annual pace since 1999, according to a Reuters poll, though activity likely picked up in the last quarter.

Mild monetary policy easing undertaken in 2012 to underpin growth has already started to push home prices higher, despite a raft of measures since 2010 to cool them.

The balance is delicate as growth has only just started to turn the corner. The same Reuters poll forecasts 2013 growth of 7.8 percent. Analysts reckon the brakes will be applied much beyond that rate.

Real estate typifies Beijing's conundrum of which levers to push forward to recalibrate growth, without pulling back too sharply on others and risk stalling its engine.

Rising real estate prices have fuelled social tension, but are also a vital source of revenue for debt-laden local governments and are generating business for off-balance sheet lending in the shadow-banking sector - which worry ratings agencies and international investors alike.

The challenge with urbanisation is that it needs more capital investment and China already invests around 50 percent of GDP. That makes the International Monetary Fund fret about the risk of creating a global glut of capacity and makes rebalancing imperative.

Despite that, a nagging question stands out for Arthur Kroeber, the firm's managing director: "Do these guys have the chops to execute on what people think needs to be done?" (Additional reporting by China Economics Team; Editing by Kim Coghill)

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